Financial Environment & Role of Financial Institutions

The economic transformation under way in the former centrally planned economies
(FCPEs) was motivated in part by the recognition that central planning has failed to allocate
financial and real resources efficiently. This paper addresses the question of what kind of
financial system should replace central planning in allocating capital and maintaining
effective corporate governance during the transformation period. Financial sector reform
has, at times, been portrayed as a question of adopting either a bank-based or a (securities)
market-based model. In the bank-based model, commercial banks, often licensed as
universal banks, take the lead in financing enterprise restructuring and investment.
Proponents of the market-based model argue that the structural problems in the banking
sector cannot be overcome easily; so firms will have to look to equity and bond markets for
sources of new capital. Equity and bond markets in the FCPEs are not sufficiently well
developed to support significant issues of new securities or to provide a mechanism for
corporate control. They lack adequate liquidity, regulatory oversight, information
disclosure, and clearing and payment systems. The important role of banks in maintaining
the payment system and in providing credit to market participants to support trading and
settlement means that until banks are restructured and recapitalized, securities market
development will be constrained.

Investment funds emerging from mass privatization schemes may create concentrations of
equity ownership that would allow them to play an important role in corporate control and
perhaps, too, in finding sources of investment capital. They are a relatively recent
innovation, however, and it remains to be seen how active they will be in financing and
managing privatized enterprises.

The authorities should first establish a healthy banking sector, because it is the banks that
are the most promising source of working capital and corporate control. This does not mean
that securities market development should be ignored, only that it should not be a priority
use of scarce government resources at the present time.

Many observers recommend that banks be given the power to act as universal banks,
combining lending with securities market operations and equity investment. The potential
problems associated with such a model in the FCPEs during the transformation period
outweigh any potential benefits. It is recommended, therefore, that commercial banking and
investment banking activities be separated, at least until banks have demonstrated
competence in their commercial lending operations.

FINANCIAL INSTITUTIONS

In financial economics, a financial institution acts as an agent that provides financial
services for its clients. Financial institutions generally fall under financial regulation from a
government authority.

Types of Financial Institutions

Banks

A bank is a commercial or state institution that provides financial services, including issuing
money in various forms, receiving deposits of money, lending money, and processing
transactions and the creating of credit.

Central Bank

A central bank, reserve bank or monetary authority, is an entity responsible for the
monetary policy of its country or of a group of member states, such as the European Central
Bank (ECB) in the European Union, the Federal Reserve System in the United States of
America, State Bank in Pakistan.

Its primary responsibility is to maintain the stability of the national currency and money
supply, but more active duties include controlling subsidized-loan interest rates, and acting
as a "bailout" lender of last resort to the banking sector during times of financial crisis
(private banks often being integral to the national financial system).

CENTRAL BANK

A central bank, reserve bank or monetary authority, is an entity responsible for the
monetary policy of its country or of a group of member states, such as the European Central
Bank (ECB) in the European Union or the Federal Reserve System in the United States of
America. Its primary responsibility is to maintain the stability of the national currency and
money supply, but more active duties include controlling subsidized-loan interest rates, and
acting as a "bailout" lender of last resort to the banking sector during times of financial
crisis (private banks often being integral to the national financial system).

It may also have supervisory powers, to ensure that banks and other financial institutions do
not behave recklessly or fraudulently. A central bank is usually headed by a governor, but
the titles are president, chief executive, and managing director respectively for the European
Central Bank the Hong Kong Monetary Authority and the Monetary Authority of
Singapore.

In most countries the central bank is state owned and has a minimal degree of autonomy,
which allows for the possibility of government intervening in monetary policy. An "Independent central bank" is one which operates under rules designed to prevent
political interference; examples include the US Federal Reserve, the Bank of England (since
1997), and the Bank of Canada, the Reserve Bank of Australia, the Banco de la República
de Colombia, and the European Central Bank.

Activities and responsibilities

Functions of a central bank (not all functions are carried out by all banks):

Implementing the basis of monetary policy

Monopoly on the issue of banknotes

Controls the nation's entire money supply

The Government's banker and the bankers' bank ("Lender of Last Resort")

Manages the country's foreign exchange and gold reserves and the Government's
stock register

Regulation and supervision of the banking industry

Setting the official interest rate - used to manage both inflation and the country's
exchange rate - and ensuring that this rate takes effect via a variety of policy
mechanisms.

POLICY INSTRUMENTS

The main monetary policy instruments available to central banks are open market operation,
bank reserve requirement, interest-rate policy, re-lending and re-discount (including using
the term repurchase market), and credit policy (often coordinated with trade policy). While
capital adequacy is important, it is defined and regulated by the Bank for International
Settlements, and central banks in practice generally do not apply stricter rules.

To enable open market operations, a central bank must hold foreign exchange reserves
(usually in the form of government bonds) and official gold reserves. It will often have
some influence over any official or mandated exchange rates: Some exchange rates are
managed, some are market based (free float) and many are somewhere in between
("managed float" or "dirty float").

Interest Rates

By far the most visible and obvious power of many modern central banks is to influence
market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number.
Although the mechanism differs from country to country, most use a similar mechanism
based on a central bank's ability to create as much fiat money as required.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used)
is generally to lend money or borrow money in theoretically unlimited quantities, until the
targeted market rate is sufficiently close to the target. Central banks may do so by lending
money to and borrowing money from (taking deposits from) a limited number of qualified
banks, or by purchasing and selling bonds. As an example of how this functions, the Bank
of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks
borrow from each other within this band, but never above or below, because the central
bank will always lend to them at the top of the band, and take deposits at the bottom of the
band; in principle, the capacity to borrow and lend at the extremes of the band are
unlimited. Other central banks use similar mechanisms.

BALANCE OF TRADE

The balance of trade is the difference between the monetary value of exports and
imports in an economy over a certain period of time.

A positive balance of trade is known as a trade surplus and consists of exporting
more than is imported;

A negative balance of trade is known as a trade deficit or, informally, a trade gap.

Physical balance of trade

Monetary balance of trade is different from physical balance of trade (which is
expressed in amount of raw materials). Developed countries usually import a lot of
primary raw materials from developing countries at low prices.

Often, these materials are then converted into finished products, and a significant
amount of value is added

Factors that can affect BOT

Exchange rates

Trade agreements or barriers

Other tax, tariff and trade measures

Business cycle at home or abroad.

Balance of Payment

The Balance of Payments (or BOP) measures the payments that flow between any
individual country and all other countries. It is used to summarize all international
economic transactions for that country during a specific time period, usually a year.

The BOP is determined by the country's exports and imports of goods, services, and
financial capital, as well as financial transfers. It reflects all payments and liabilities
to foreigners (debits) and all payments and obligations received from foreigners
(credits).

STATE BANK OF PAKISTAN

The State Bank of Pakistan (SBP) is the central bank of Pakistan. While its constitution,
as originally lay down in the State Bank of Pakistan Order 1948, remained basically
unchanged until January 1, 1974, when the bank was nationalized, the scope of its functions
was considerably enlarged. The State Bank of Pakistan Act 1956, with subsequent
amendments, forms the basis of its operations today. The headquarters are located in the
financial capital of Pakistan, Karachi with its second headquarters in the capital, Islamabad.

History

Before independence on 14 August 1947, the Reserve Bank of India (central bank of India)
was the central bank for what is now Pakistan. On 30 December 1948 the British
Government's commission distributed the Bank of India's reserves between Pakistan and
India - 30 percent (750 M gold) for Pakistan and 70 percent for India.

The losses incurred in the transition to independence were taken from Pakistan's share (a
total of 230 million). In May, 1948 Muhammad Ali Jinnah (Founder of Pakistan) took steps
to establish the State Bank of Pakistan immediately. These were implemented in June 1948,
and the State Bank of Pakistan commenced operation on July 1, 1948.

Functions

Under the State Bank of Pakistan Order 1948, the state bank of Pakistan was charged with
the duty to "regulate the issue of bank notes and keeping of reserves with a view to securing
monetary stability in Pakistan and generally to operate the currency and credit system of the
country to its advantage".

STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS

Agricultural Credit Department

Established under Section 8(3) of SBP Act 1956, is mainly responsible to meet credit needs
of agriculture that being the mainstay of Pakistan’s economy generates nearly one fourth of
the total out put and 44% of total employment and is the major source of foreign exchange
earning.

To operate as a focal point in SBP for all agriculture and rural finance policies,
programs and projects.

To assess/estimate the credit needs of farm & non farm sector in rural areas.
To review the issues and challenges faced and developments taking place in agriculture and
rural finance both in the country and elsewhere to develop an adequate knowledge and
information base for policy formulation etc

STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)

Islamic Banking Department

Islamic Banking Department was established on 15th September, 2003 and has been
entrusted with the huge task of promoting & developing the Shariah Compliant
Islamic Banking as a parallel and compatible banking system in the country.

State Bank of Pakistan wants to develop a progressive and sound Islamic banking
system that is in line and compatible with the global financial sector, providing
innovative Shariah compliant products and services so as to achieve equitable
economic growth.

One of the biggest challenges being faced by this growing industry is the dearth of
professional Islamic Bankers and capacity building in this regard is one of the top
most priorities for the promotion of Islamic Banking.

In order to play our regulatory and supervisory role more efficiently we are working
on the areas like Risk Management, Corporate Governance, Prudential Regulations,
Accounting & Shariah Standards etc. regarding Islamic Banking

Islamic Banking Department consists of following four divisions:

Policy Division

Shariah Compliance Division

Business Support Division

Shariah Board Secretariat

Islamic Banking is one of the emerging field in global financial market, having tremendous
potential and growing at a very fast pace all around the world.

STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)

Banking Surveillance Department

Health of an economy depends on the degree of safety and stability of its banking and
financial system. A sound, stable, and robust banking and financial system is a pre-requisite
for economic well being of a country and its populace. In Pakistan, ensuring the stability
and soundness of the banking system is a statutory responsibility of State Bank of Pakistan.
The banking supervision departments viz. Banking Policy and Regulations Department
(BP&RD), Banking Surveillance Department (BSD), Off-Site Supervision and Enforcement
Department (OSSED) and Banking Inspection Department have been assigned this
important function to work jointly and severally to ensure the soundness of individual banks
and of overall banking industry. The Department is responsible to supervise financial
institutions in the country. The department ensures effective adherence to regulatory &
supervisory policies, monitors risk profiles, evaluate operating performance of individual
banks/DFIs & the industry as a whole while issuing guidelines for managing various types
of risks. It also ensures that banks are adequately capitalized & have policies & systems in
place to assess various risks. The department is also responsible for the implementation of
the Basel II Accord in Pakistan. The function & activities of Credit Information Bureau also
falls within the domain of Banking Surveillance Department. The CIB collect credit data,
under section 25A of the Banking Companies Ordinance 1962, maintain its database &
disseminate credit information to financial institutions online to facilitate their credit
appraisal process.

STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)

Exchange Policy Department

(EPD) one of the core departments of the State Bank is responsible for overall stability of
the foreign exchange market and is engaged in the process of policy formulation and
implementation. It reviews on continuous basis, the existing rules and regulations, to
facilitate foreign exchange activities in the country. Foreign exchange business in Pakistan
is governed / regulated under Foreign Exchange Regulations Act, 1947 (FERA, 1947).
Exchange Policy Department is structured into three divisions namely:

2. Investment Division:

This division primarily facilitates implementation and compliance of policy of the
Government for investments in Pakistan and abroad. This is carried out by offering
feedback on matters of varied natures, reviewing and updating of investment related policies
and activities and operational management

3. Exchange Companies Division:

Policy formulation for establishing Exchange Companies & ensuring adequate framework
for licensing, operating, effective supervision & monitoring thereof are the prime
responsibilities of Exchange Companies Division. These activities are carried out in close
coordination with other the Field Offices of SBP-BSC and concerned government
functionaries etc. It also organizes training and development activities for the respective
financial institutions and concerned bodies.

MAJOR DRIVERS OF FINANCIAL INDUSTRY

MACRO ECONOMIC PERFORMANCE OF A COUNTRY

National Income

People of any country produce a specific quantity of different goods and services from the
natural resources by the help of capital goods with in a specific period, usually one year and
this is called income of a country

Concepts of National Income

Gross National Product “GDP” or Gross National Income “GNI” GDP or GNI is defined as “the total market value of all the final goods and services produced in a
year.”

Net National Product “NNP” or Net National Income “NNP” “It means net value
of all the goods and services produced in a country during a year is called Net
National Income.”

Difference b/w GDP & GNP

GDP is the value of goods and services in the country during a year minus the value
of inputs.

GNP represents GDP plus net factor income payments from abroad.

MAJOR DRIVERS OF FINANCIAL INDUSTRY

Regulating risk and the importance of risk management

Key challenge for regulators is to find ways to manage risks adequately. They have to
ensure the prudential soundness of financial institutions and the stability of the system at
large. But they also have to avoid stifling innovation and limiting the growth potential of the
institutions concerned.

INTERNATIONAL FINANCIAL INSTITUTIONS

World Trade Organization

(WTO) is an international organization designed to supervise and liberalize international
trade. The WTO came into being on January 1, 1995, and is the successor to the General
Agreement on Tariffs and Trade (GATT), which was created in 1947, and continued to
operate for almost five decades as a de facto international organization. The WTO is
governed by a Ministerial Conference, which meets every two years; a General Council,
which implements the conference's policy decisions and is responsible for day-to-day
administration; and a director-general, who is appointed by the Ministerial Conference. The
WTO's headquarters are in Geneva, Switzerland.

Criticism on WTO

Although the stated aim of the WTO is to promote free trade and stimulate economic
growth, some believe that globally free trade results in the rich (both people and countries)
becoming richer, while the poor are getting poorer. Martin Khor, Director of the Third
World Network, argues that the WTO does not manage the global economy impartially, but
in its operation has a systematic bias toward rich countries and multinational corporations,
harming smaller countries which have less negotiation power. He argues that developing
countries have not benefited from the WTO Agreements of the Uruguay Round, because
(among other reasons): market access in industry has not improved; these countries have no
gains yet from the phasing out of textiles quotas; non-tariff barriers such as anti-dumping
measures have increased; domestic support and export subsidies for agricultural products in
the rich countries remain high. Other critics have characterized the decision making in the
WTO as complicated, ineffective, unrepresentative, and non-inclusive, and they have
proposed the establishment of a small, informal steering committee (a "consultative board")
that can be delegated responsibility for developing consensus on trade issues among the
member countries.

PAKISTAN ECONOMIC AID & DEBT

The Asian Development Bank will provide close to $ 6 billion development assistance to
Pakistan during 2006-9. The World Bank unveiled a lending program of up to $6.5 billion
for Pakistan under a new four-year, 2006-2009, aid strategy showing a significant increase
in funding aimed largely at beefing up the country's infrastructure. Japan will provide $500
million annual economic aid to Pakistan.

The major causes of poverty in Pakistan

Lack of employment opportunities, which in the rural setting is caused by the
absence of rural-urban linkages.

A slowdown in the pace of economic growth in the 1990s

With the burgeoning debt obligations, a decline in the public sector development
program.

Key challenges facing the Government of Pakistan

Restoring economic growth-constrained further by a drought-affected agriculture
sector

Managing the large debt burden with international financial institutions.

Promoting domestic and foreign investors' confidence

Increasing exports to generate foreign exchange,

Maintaining a level of social development spending to stem the deteriorating social
indicators.

Law and Order, or Terrorism

Future Prospects for Pakistan's Economy

Pakistan's long term prospects will depend upon the interplay of evolution in political and
social developments, economic policies to be pursued, the quality of governance and
institutions, and most important investment in the human capital. It has become quite
obvious from both Pakistan's own history and the experience of the developing countries
that sustained economic growth and poverty reduction cannot take place merely on the
strength of economic policies. Political stability, social cohesion, supporting institutions,
and good governance are equally important ingredients coupled with both external
environments for achieving economic success.

INCREASING FOREIGN DIRECT INVESTMENT

Pakistan must increase Foreign Direct Investment, if it intends to enhance the growth of its
economy. The experience of the developing countries is that FDI is directly related to
economic growth. Two recent examples from the developing world are China and India.

The following factors have proven to be critical for attracting foreign investment:

World-class physical infrastructure

A secure law and order situation

Skilled and productive labor

Innovative capacities

Agglomeration of efficient suppliers, competitors

A well-developed institutional infrastructure

Foreign Interest in Local Financial Markets

With the rapid growth in Pakistan's economy, foreign investors are taking a keen interest in
the corporate sector of Pakistan. In the recent years, majority stakes in many corporations
have been acquired by multinational groups.

Enhancing and Sustaining a Growing GDP

There have been two problems with the GDP growth rate in Pakistan. First, Pakistan has not
been able to sustain growth over the long term. Sometimes Pakistan grows at a rate of
around 7 percent and sometimes it retreats to a 3 percent growth rate.
Second, the growth rate of the economy in Pakistan has not been linked to improvement in
human development factors. Basic indicators like education, health, poverty, safe drinking
water, etc., have been neglected in Pakistan. The "trickle down theories" and market forces
of the 1970s and 1980s have failed to provide relief for the general public. A need exists to
link the growth rate of the economy to improvement in human development. The basic
argument is that a higher growth rate is of limited utility if it does not benefit the population
as a whole, including the poor.

ROLE OF COMMERCIAL BANKS

A bank is a commercial or state institution that provides financial services, including
issuing money in various forms, receiving deposits of money, lending money and
processing transactions and the creating of credit

A commercial bank accepts deposits from customers and in turn makes loans, even in
excess of the deposits; a process known as fractional-reserve banking. Some banks (called
Banks of issue) issue banknotes as legal tender. A commercial bank is usually defined as
an institution that both accepts deposits and makes loans; there are also financial institutions
that provide selected banking services without meeting the legal definition of a bank. Many
banks offer ancillary financial services to make additional profit; for example, most banks
also rent safe deposit boxes in their branches. Currently in most jurisdictions commercial
banks are regulated & require permission to operate. Operational authority is granted by
bank regulatory authorities who provide rights to conduct the most fundamental banking
services such as accepting deposits and making loans.

Purpose of a bank:

Banks have influenced economies & politics for centuries. Historically, the primary
purpose of a bank was to provide loans to trading companies. Banks provided funds to
allow businesses to purchase inventory, and collected those funds back with interest when
the goods were sold.

Commercial Lending:

For centuries, the banking industry only dealt with businesses, not consumers. Commercial
lending today is a very intense activity, with banks carefully analyzing the financial
condition of their business clients to determine the level of risk in each loan transaction.

ROLE OF COMMERCIAL BANKS

Types of investment banks

Investment banks "underwrite" (guarantee the sale of) stock and bond issues,
trade for their own accounts, make markets, and advise corporations on capital
markets activities such as mergers and acquisitions.

Merchant banks were traditionally banks which engaged in trade financing. The
modern definition, however, refers to banks which provide capital to firms in the
form of shares rather than loans. Unlike Venture capital firms, they tend not to
invest in new companies

Banks in the Economy

Role in the money supply

A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or
issuing financial instruments in the money market or a capital market. The bank then lends
out most of these funds to borrowers. However, it would not be prudent for a bank to lend
out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it
can repay depositors who withdraw their deposits.

Bank reserves are typically kept in the form of a deposit with a central bank. This is called
fractional-reserve banking and it is a central issue of monetary policy.

Note that under Basel I (and the new round of Basel II), banks no longer keep deposits with
central banks, but must maintain defined capital ratios

ROLE OF COMMERCIAL BANKS

Public perceptions of banks

In United States history, the National Bank was a major political issue during the
presidency of Andrew Jackson. Jackson fought against the bank as a symbol of greed
and profit-mongering, antithetical to the democratic ideals of the United States.

Currently, many people consider that various banking policies take advantage of customers.
In Canada, for example, the New Democratic Party has called for the abolition of user fees
for automated teller transactions. Other specific concerns are policies that permit banks to
hold deposited funds for several days, to apply withdrawals before deposits or from greatest
to least, which is most likely to cause the greatest overdraft, that allow backdating funds
transfers and fee assessments, and that authorize electronic funds transfers despite an
overdraft.

In response to the perceived greed and socially-irresponsible all-for-the-profit attitude of
banks, in the last few decades a new type of bank called ethical banks have emerged, which
only make socially-responsible investments (for instance, no investment in the arms
industry) and are transparent in all its operations.

In the US, credit unions have also gained popularity as an alternative financial resource for
many consumers. Also, in various European countries, cooperative banks are regularly
gaining market share in retail banking.

Profitability

Large banks in the United States are some of the most profitable corporations, especially
relative to the small market shares they have. This amount is even higher if one counts the
credit divisions of companies like Ford, which are responsible for a large proportion of
those companies' profits.

ROLE OF COMMERCIAL BANKS

Asset composition

Assets of banking sector, as per cent of GDP, have been on the decline. Slowdown in asset
growth was also accompanied by changing share of different groups. Negative growth in the
assets of foreign banks during 1998 and 1999 was the prime reason behind declining growth
in overall assets of the banking sector. Share of NCBs have been decreasing since private
banks were allowed to operate in 1992. In terms of asset share, private banks are now as
large as foreign banks.

Problem bank management

The central bank is the sole authority to supervise, monitor and regulate financial
institutions. It is also responsible to safeguard the interest of depositors and shareholders of
these institutions. Lately, SBP took actions against two private banks which became a threat
to viability of the financial system in the country. These were Indus Bank and Prudential
Commercial Bank. On the basis of detailed investigations, the license of Indus Bank was
cancelled on September 11, 2000. After successful negotiations, management and control of
Prudential Bank handed over to Saudi-Pak group.

Outlook

Commercial banks have been going through the process of restructuring. There are efforts
to reduce lending rates. The SBP has been successful in implementing its policies. Most of
the banks have been able to adjust to new working environment. The proposed increase in
capital base will provide further impetus to financial system in the country.
In the post September 11 era, the GoP borrowing from SBP and commercial banks is
expected to come down substantially and private sector borrowing to increase. However, a
temporary decline in repayment ability of borrowers may increase provisioning for the year
2001. The situation is expected to improve in year 2002. Unless efforts are made by banks
to shrink spread, depositors will not be able to get return which corresponds with the rate of
inflation in the country. Privatization of NCBs is expected to be delayed due to external factors. However, it is an opportunity for the banks to further clean their slate. Pakistan’s
banking sector like many other developing countries had been faced with several problems
and difficulties such as:
Most of the financial assets and deposits were owned by nationalized commercial banks
(NCBs) which suffered from a highly bureaucratic approach, overstaffing, unprofitable
branches and poor customer service.

ROLE OF COMMERCIAL BANKING

12. Legal Reforms

Legal difficulties and time delays in recovery of defaulted loans have been removed through
a new ordinance i.e. The Financial Institutions (Recovery of Finances) Ordinance, 2001.
The new recovery laws ensures expeditious recovery of stuck up loans by the right of
foreclosure and sale of mortgaged property with or without intervention of court and
automatic transfer of case to execution proceeding. A Banking Laws Reforms Commission
is reviewing, revising, and consolidating the banking laws and drafting new laws such as
bankruptcy law.

13. Taxation

The corporate tax rates on banks were exorbitantly high in Pakistan thus adversely affecting
their profitability and attractiveness as an avenue for investment and new equity injection.
The Government has already reduced the tax rate from 58 percent to 44 percent during the
last three years and it is envisaged that the rate will be reduced gradually and brought at par
with the corporate tax rate of 35 percent in the next three years. This will in turn help in
reducing the spread between the deposit rate and lending rate and benefit financial savers.

14. Agriculture Credit

A complete revamping of Agriculture Credit Scheme has been done recently with the help
of commercial banks. The scope of the Scheme which was limited to production loans for
inputs has been broadened to the whole value chain of agriculture sector.
We have, with the grace of Allah, become a surplus country in food grains, livestock etc.
and thus the needs of agriculture sector have also expanded. The SBP has included
financing for silos, god-owns, refrigerated vans, agro processing and distribution under the
cover of this scheme. This broadening of the scope as well the
removal of other restrictions have enabled the commercial banks to increase their lending
for agriculture by a multiple of four times compared to FY 1999-00 thus mainstreaming
agriculture lending as part of their corporate business. Unlike the previous years when they
were prepared to pay penalties for under performance they have set up higher targets for this
year. The private commercial banks have also agreed to step in and increase their lending to
agriculture.

BRANCH BANKING IN PAKISTAN

A branch, banking centre or financial centre is a retail location where a bank or financial
institution offers a wide array of face to face service to its customers.

Remittances:

Demand Draft

It’s a written order, drawn by one branch of a bank upon another branch of the same bank,
upon other bank under special arrangement to pay a certain sum of money to or to the order
of a specified person.”

Parties Involved

Purchaser

Issuing Branch

Drawee Branch

Payee/ Beneficiary

Pay Order

A Pay Order is a written authorization for Pmt, Made in a receipt from issued & Payable by
the bank, to the person named & addressed therein on his giving a proper discharge thereon.

ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR

Microfinance in its broadest terms can be defined as provision of a range of financial
services such as deposits, loans, payment services, money transfers and insurance to poor
and low income households, and their micro enterprises (Source: Asian Development bank
report on microfinance development strategy). While a commercial bank is a financial
institution that offers a broad range of deposit accounts, including checking, savings, and
time deposits, and extends loans to individuals and businesses.

The decision as to whether the commercial banks be involved in microfinance is a sensitive
and debatable issue which requires a deep analysis of many factors.

Primarily, the microfinance customers are large in number, scattered in far-flung areas with
very minute transaction sizes. Only government or state bank alone cannot reach out to
millions of potential Microfinance beneficiaries; a whole well knitted network with almost
doorstep reach is required, which is only possible when the commercial banks will be
involved in microfinance. In Pakistan it is estimated that as many as 5.6 million households
need microfinance services but these services reach only to less than 1 percent, most
probably because of the absence of commercial banks from the microfinance sector.
(Source: Pakistan microfinance Network PMN) This way a poor person just need to visit
his local commercial bank to get access to microfinance benefits, which will help reduce
many economic problems.
One criticism over involving the commercial banks in microfinance is that commercial
banks will charge higher interest rates, further lower the standard of living and will exploit
the public. The ground realities are totally different; empirical evidence has demonstrated
that participants in microfinance programs have improved their living standards at both the

Mutual funds

What are mutual funds?

An investment vehicle which is comprised of a pool of funds collected from many investors
for the purpose of investing in securities such as stocks, bonds, money market securities,
and similar assets. Mutual funds are operated by money mangers, who invest the fund's
capital and attempt to produce capital gains and income for the fund's investors. A mutual
fund's portfolio is structured and maintained to match the investment objectives stated in its
prospectus.

In business encyclopedia

Mutual funds belong to a group of financial intermediaries known as investment companies,
which are in the business of collecting funds from investors and pooling them for the
purpose of building a portfolio of securities according to stated objectives. They are also
known as open-end investment companies. Other members of the group are closed-end
investment companies (also known as closed-end funds) and unit investment trusts. In the
United States, investment companies are regulated by the Securities and Exchange
Commission under the Investment Company Act of 1940.

Mutual funds are generally organized as corporations or trusts, and, as such, they have a
board of directors or trustees elected by the shareholders. Almost all aspects of their
operations are externally managed. They engage a management company to manage the
investment for a fee, generally based on a percentage of the fund's average net assets during
the year. The management company may be an affiliated organization or an independent
contractor. They sell their shares to investors either directly or through other firms such as
broker-dealers, financial planners, employees of insurance companies, and banks. Even the
day-to-day administration of a fund is carried out by an outsider, which may be the
management company or an unaffiliated third party.

Mutual Funds

Criticism of managed mutual funds

Historically, only a small percentage of actively managed mutual funds, over long periods
of time, have returned as much, or more than comparable index mutual funds. This, of
course, is a criticism of one type of mutual fund over another.

Another criticism concerns sales commissions on load funds, an upfront or deferred
fee as high as 8.5 percent of the amount invested in a fund (although the average upfront
load is no more than 5% normally). *(Mutual Funds have to qualify to charge
the maximum allowed by law, which is 8.5% and most of them DO NOT qualify for
this.)

In addition, no-load funds typically charge a 12b-1 fee in order to pay for shelf space
on the exchange the investor uses for purchase of the fund, but they do not pay a
load directly to a mutual fund broker, who sells it.

Critics point out those high sales commissions can sometimes represent a conflict of
interest, as high commissions benefit the sales people but hurt the investors.
Although in reality, "A shares", which appear to have the highest up front load,
(around 5%) are the "cheapest" for the investor, if the investor is planning on 1)
keeping the fund for more than 5 years, 2) investing more than 100,000 in one fund
family, which likely will qualify them for "break points”, which is a form of
discount, or 3) staying with that "fund family" for more than 5 years, but switching
"funds" within the same fund company. In this case, the up front load is best for the
client, and at times "outperforms" the "no load" or "B or C shares".

High commissions can sometimes cause sales people to recommend funds that
maximize their income. This can be easily solved, buy working with a "registered
investment advisor" instead of a "broker", where the investment advisor can charge
strictly for advise, and not charge a "load, or commission" for their work, at all.

This is a discussion of criticism, and solutions regarding one mutual fund over another.12b-
1 fees, which are found on most "no load funds”, can motivate the fund company to focus
on advertising to attract more and more new investors, as new investors would also cause
the fund assets to increase, thus increasing the amount of money that the mutual fund
managers make.

Mutual Funds

Balanced Funds

The basic objectives of balanced funds are to generate income as well as long-term growth
of principal. These funds generally have portfolios consisting of bonds, preferred stocks,
and common stocks. They have fairly limited price rise potential, but do have a high degree
of safety, and moderate to high income potential.

Investors who desire a fund with a combination of securities in a single portfolio, and who
seek some current income and moderate growth with low-level risk, would do well to invest
in balanced mutual funds. Balanced funds, by and large, do not differ greatly from the
growth and income funds described above.

Growth Funds

Growth funds are offered by every investment company. The primary objective of such
funds is to seek long-term appreciation (growth of capital). The secondary objective is to
make one's capital investment grow faster than the rate of inflation. Dividend income is
considered an incidental objective of growth funds.

Growth funds are best suited for investors interested primarily in seeing their principal grow
and are therefore to be considered as long-term investments - held for at least three to five
years. Jumping in and out of growth funds tends to defeat their purpose. However, if the
fund has not shown substantial growth over a three - to five-year period, sell it (redeem your
shares) and seek a growth fund with another investment company. Candidates likely to
participate in growth funds are those willing to accept moderate to high risk in order to
attain growth of their capital and those investors who characterize their investment
temperament as "fairly aggressive.

Mutual Funds

Cost of Ownership

1. Management Fee

All mutual funds, including no-load funds, have certain fixed expenses that are built into
their per share net asset value. These expenses are the actual costs of doing business.

They are deducted from the assets of the fund. It is advisable to check the prospectus to
determine the percentage of the fund's total net assets that is paid out for expenses.

Additionally, shareholder services provided by the fund, investment adviser's fees, bank
custodian fees, and fund underwriter costs also come out of the fund's assets. These charges
vary from fund to fund; however, they are clearly spelled out in the prospectus.

On a per-share basis, however, management expenses are usually quite small, because they
are spread over the tens of thousands, or the millions, of shareholders in the fund.

The formula for determining the cost of a fund's management expenses is simple: From the
current value of the fund's total assets subtract liabilities and expenses, and divide the result
by the number of outstanding shares. The fund's prospectus and /or annual reports often
provide this data. Management fees and expenses are usually expressed as a ratio of
expenses paid out to total assets. Generally, the prospectus will show these expense ratios.

Mutual Funds

Navigating the Investing Frontier: Where the Frauds Are

Many fraudsters rely on the telephone to carry out their investment scams. Using a
technique known as cold calling (so-called because a caller telephones a person with whom
they have not had previous contact), these fraudsters will hound you to buy stocks in small,
unknown companies that are highly risky or, sometimes, part of a scam. In recent years, the
Internet has also become increasingly attractive to fraudsters because it allows an individual
or company to communicate with a large audience without spending a lot of time, effort, or
money.

You should be skeptical of any offers you learn about from a cold caller or through the
Internet. Here's what you need to know about cold calling and Internet fraud.

Cold calling

For many businesses, including securities firms, cold calling serve as a legitimate way to
reach potential customers. Honest brokers use cold calling to find clients for the long term.
They ask questions to understand your financial situation and investment goals before
recommending that you buy anything.

Dishonest brokers use cold calling to find "quick hits." Some set up "boiler rooms" where
high-pressure salespeople use banks of telephones to call as many potential investors as
possible. Aggressive cold callers speak from persuasive scripts that include retorts for your
every objection. As long as you stay on the phone, they'll keep trying to sell. And they won't
let you get a word in edgewise. Our advice is to avoid making any direct investments over
the phone.

Mutual Funds

Investing In International Mutual Funds

Investing in international mutual funds has two faces:

First is buying funds from US based companies that buy and manage portfolio in
internationally listed stocks/securities. These companies are governed by regulations
of SEC (Securities and Exchange Commission)

Second is buying mutual funds from international non US companies.

A word of caution before investing even in best international mutual funds - Unlike
domestic mutual funds investment, international investments entail additional risk factors
such as economic and political in addition to risk of FOREX value (simply put: foreign
currency exchange value) fluctuations.

Why Should You Invest In International Opportunities?

The number of funds in international investing is on the rise. We can cite a few reasons for
this.

Removal of trade barriers and expanding of economies have sparked off growth in
many non-US companies.

Some of the major industries of the world are dominated by non US companies.

Over 72% of the world stocks are listed out side US.

Greater and true diversification and opportunity to capitalize on best overseas
companies.

Investing in international mutual funds is gaining popularity for various reasons. Rising
political stability merging or opening of borders and currencies are some of the reasons.
Vibrant and upcoming economies and non US corporations becoming financially stronger
by the day are some of the reasons. In addition you get true diversification, balance and
opportunities.

Role of Investment Banks

Investment banks

It helps companies and governments (or their agencies) raise money by issuing and selling
securities in the capital markets (both equity and debt).

Almost all investment banks also offer strategic advisory services for mergers, acquisitions,
divestiture, or other financial services for clients, such as the trading of derivatives, fixed
income, and foreign exchange, commodity, and equity securities.

Trading securities for cash or securities (i.e., facilitating transactions, market-making), or
the promotion of securities (i.e., underwriting, research, etc.) is referred to as "sell side."

The "buy side" constitutes the pension funds, mutual funds, hedge funds, and the investing
public who consume the products and services of the sell-side in order to maximize their
return on investment. Many firms have both buy and sell side components.

Organizational structure of an investment bank

The main activities and units

The primary function of an investment bank is buying and selling products both on behalf of
the bank's clients and also for the bank itself. Banks undertake risk through proprietary
trading, done by a special set of traders who do not interface with clients and through
Principal Risk, risk undertaken by a trader after he or she buys or sells a product to a client
and does not hedge his or her total exposure. Banks seek to maximize profitability for a
given amount of risk on their balance sheet.

Letter of Credit

Commercial Letter of Credit

Commercial letters of credit have been used for centuries to facilitate payment in
international trade. Their use will continue to increase as the global economy evolves.

Letters of credit used in international transactions are governed by the International
Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The
general provisions and definitions of the International Chamber of Commerce are binding
on all parties. Domestic collections in the United States are governed by the Uniform
Commercial Code.

A commercial letter of credit is a contractual agreement between banks, known as the
issuing bank, on behalf of one of its customers, authorizing another bank, known as the
advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the
request of its customer, opens the letter of credit. The issuing bank makes a commitment to
honor drawings made under the credit. The beneficiary is normally the provider of goods
and/or services. Essentially, the issuing bank replaces the bank's customer as the payee.

Elements of a Letter of Credit

A payment undertaking given by a bank (issuing bank)

On behalf of a buyer (applicant)

To pay a seller (beneficiary) for a given amount of money

On presentation of specified documents representing the supply of goods

Within specified time limits

Documents must conform to terms and conditions set out in the letter of credit

Letter of Credit and International Trade

A letter of credit is a document issued mostly by a financial institution which usually
provides an irrevocable payment undertaking (it can also be revocable, confirmed,
unconfirmed, transferable or others e.g. back to back: revolving but is most commonly
irrevocable/confirmed) to a beneficiary against complying documents as stated in the Letter
of Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a
documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply
as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank
acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any,
within the expiry date of the LC, comprising documents complying with the terms and
conditions of the LC, the applicable UCP and international standard banking practice, the
issuing bank or confirming bank, if any, is obliged to honor irrespective of any instructions
from the applicant to the contrary. In other words, the obligation to honor (usually payment)
is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks can
also issue letters of credit however parties must balance potential risks.

The LC can also be the source of payment for a transaction, meaning that an exporter will
get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in
international trade transactions of significant value, for deals between a supplier in one
country and a wholesale customer in another. They are also used in the land development
process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.)
will be built. The parties to a letter of credit are usually a beneficiary who is to receive the
money, the issuing bank of whom the applicant is a client, and the advising bank of whom
the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e.
cannot be amended or cancelled without prior agreement of the beneficiary, the issuing
bank, and the confirming bank, if any). However, the applicant is not a party to the letter of
credit. In executing a transaction, letters of credit incorporate functions common to giros
and Traveler's cheque. Typically, the documents a beneficiary has to present in order to
avail him of the credit are commercial invoice, bill of lading, insurance documents.
However, the list and form of documents is open to imagination and negotiation and might
contain requirements to present documents issued by a neutral third party evidencing the
quality of the goods shipped.

Foreign Exchange & Financial Institutions

The foreign exchange (currency or forex or FX) market exists wherever one currency is
traded for another. It is by far the largest financial market in the world, and includes trading
between large banks, central banks, currency speculators, multinational corporations,
governments, and other financial markets and institutions. The average daily trade in the
global forex and related markets currently is over US$ 3 trillion. Retail traders (individuals)
are a small fraction of this market and may only participate indirectly through brokers or
banks, and are subject to forex scams.

Market size and liquidity

The foreign exchange market is unique because of

its trading volume,

the extreme liquidity of the market,

the large number of, and variety of, traders in the market,

its geographical dispersion,

its long trading hours: 24 hours a day (except on weekends),

The variety of factors that affect exchange rates.

the low margins of profit compared with other markets of fixed income (but profits
can be high due to very large trading volumes)

According to the BIS, average daily turnover in traditional foreign exchange markets is
estimated at $3,210 billion. Daily averages in April for different years, in billions of US
dollars, are presented on the chart below:

Foreign Exchange

Factors affecting currency trading

Although exchange rates are affected by many factors, in the end, currency prices are a
result of supply and demand forces. The world's currency markets can be viewed as a huge
melting pot: in a large and ever-changing mix of current events, supply and demand factors
are constantly shifting, and the price of one currency in relation to another shifts
accordingly. No other market encompasses (and distills) as much of what is going on in the
world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any
single element, but rather by several. These elements generally fall into three categories:
economic factors, political conditions, and market psychology.

Economic factors

These include economic policy, disseminated by government agencies and central banks,
economic conditions, generally revealed through economic reports, and other economic
indicators.

Economic policy comprises government fiscal policy (budget/spending practices) and
monetary policy (the means by which a government's central bank influences the supply and"cost" of money, which is reflected by the level of interest rates).

Leasing Companies

A lease or tenancy is a contract that transfers the right to possess specific property.
In law, there are two types of property: historically, land is the more important
because, under normal circumstances, it holds the highest value in economically
developed societies. Ownership of land is an aspect of the system of real property or
realty in common law systems.

When structured as an operating lease, this is a form of financing that avoids the
down payment usually required for the purchase of equipment. Because leased
equipment is not owned by the company, it does not appear on the balance sheet. A
financing lease does appear on the balance sheet.

Don't be intimidated! For most people, leasing is an unfamiliar concept and
therefore a little scary, but leasing isn't any more difficult than purchasing a car.
Fully understanding how the leasing process works is the first step toward a positive
leasing experience.

Leasing a vehicle is similar to renting a car, just for a longer time period. Like renting a car,
a person who leases pays a pre-determined rate to drive a vehicle for a pre-determined
amount of time. You never own the vehicle and return it when your lease is up. A person
who leases enjoys the benefits of driving a car without assuming the up-front costs, and
many of the risks of ownership.

Basic Purpose of Leasing

Bargain Purchase Option

A lease provision allowing the lessee, at its option, to purchase the equipment for a price
predetermined at lease inception that is substantially lower than the expected fair market
value at the date the option can be exercised.

The Leasing Sector in Pakistan and its Role in Capital Investment

From the Third World perspective where a major source of economic capital is a form of
foreign or local debt, Leasing acts as a hybrid form of debt cum investment. In the 80’s,
when Pakistan floated its first leasing company, the characteristic of ‘asset-based’ financing
made it a more ‘Islamic’ form of lending. (Asset based lending is a permitted form of debtfinancing
in Islam). From the perspective of developmental finance, Leasing provided an
alternative to interest based debt.

Leasing as investment indicator

Hypothetically, since leasing is directly related to the acquisition of an asset, indicating the
Aggregate Investment in Leasing (AIL) of the leasing sector, in a country and at a point in
time, would indicate the amount of incremental and fresh capital investment in a year.
Hypothetically, we may ignore ‘leakages’ such as rescheduling and duplicate leasing.

The aggregate figure for ‘Investment in Leasing’ for the leasing sector in Pakistan has been
ranging between PKR18bn to PKR25bn over the past three years. We do not have statistics
regarding the exact percentage of new investment in plant and machinery or other income
generating assets. I think I can safely estimate about 90% of the AIL is plant and machinery.
Of-course, the AIL is only indicative of new capital investment if compared with the same
over the previous year. A fairly rough estimate of incremental capital investment would
therefore be an average of Rs3billion per year. This does not mean all new investment in a
year. That would be much higher since part of the AIL would be paid back, depending on
the life of the lease contract.

Role of Insurance Companies

Insurance, in law and economics, is a form of risk management primarily used to hedge
against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk
of a loss, from one entity to another, in exchange for a premium. Insurer, in economics, is
the company that sells the insurance. Insurance rate is a factor used to determine the
amount, called the premium, to be charged for a certain amount of insurance coverage.
Risk management, the practice of appraising and controlling risk, has evolved as a discrete
field of study and practice.

Principles of insurance

A large number of homogeneous exposure units. The vast majority of insurance
policies are provided for individual members of very large classes. Automobile
insurance, for example, covered about 175 million automobiles in the United States
in 2004.[2] The existence of a large number of homogeneous exposure units allows
insurers to benefit from the so-called “law of large numbers,” which in effect states that
as the number of exposure units increases, the actual results are increasingly likely
to become close to expected results. There are exceptions to this criterion. Lloyd's of
London is famous for insuring the life or health of actors, actresses and sports figures.
Satellite Launch insurance covers events that are infrequent. Large commercial
property policies may insure exceptional properties for which there are no
‘homogeneous’ exposure units. Despite failing on this criterion, many exposures like
these are generally considered to be insurable.

Definite Loss. The event that gives rise to the loss that is subject to insurance
should, at least in principle, take place at a known time, in a known place, and from
a known cause. The classic example is death of an insured on a life insurance policy.
Fire, automobile accidents, and worker injuries may all easily meet this criterion.
Other types of losses may only be definite in theory. Occupational disease, for
instance, may involve prolonged exposure to injurious conditions where no specific
time, place or cause is identifiable. Ideally, the time, place and cause of a loss should
be clear enough that a reasonable person, with sufficient information, could
objectively verify all three elements.

Accidental Loss. The event that constitutes the trigger of a claim should be
fortuitous, or at least outside the control of the beneficiary of the insurance. The loss
should be ‘pure,’ in the sense that it results from an event for which there is only the
opportunity for cost. Events that contain speculative elements, such as ordinary
business risks, are generally not considered insurable.

Role of Insurance Companies

Types of insurance

Any risk that can be quantified can potentially be insured. Specific kinds of risk that may
give rise to claims are known as "perils". An insurance policy will set out in detail which
perils are covered by the policy and which is not.

Below is a (non-exhaustive) list of the many different types of insurance that exist.
A single policy may cover risks in one or more of the categories set forth below. For
example, auto insurance would typically cover both property risk (covering the risk
of theft or damage to the car) and liability risk (covering legal claims from causing
an accident). A homeowner's insurance policy in the U.S. typically includes property
insurance covering damage to the home and the owner's belongings, liability
insurance covering certain legal claims against the owner, and even a small amount
of health insurance for medical expenses of guests who are injured on the owner's
property.

Automobile insurance, known in the UK as motor insurance, is probably the most
common form of insurance and may cover both legal liability claims against the
driver and loss of or damage to the insured's vehicle itself. Throughout most of the
United States an auto insurance policy is required to legally operate a motor vehicle
on public roads. In some jurisdictions, bodily injury compensation for automobile
accident victims has been changed to a no-fault system, which reduces or eliminates
the ability to sue for compensation but provides automatic eligibility for benefits.
Credit card companies insure against damage on rented cars.

Boiler insurance (also known as boiler and machinery insurance or equipment
breakdown insurance) insures against accidental physical damage to equipment or
machinery.

Builder's risk insurance insures against the risk of physical loss or damage to
property during construction. Builder's risk insurance is typically written on an "all
risk" basis covering damage due to any cause (including the negligence of the
insured) not otherwise expressly excluded.

Business insurance can be any kind of insurance that protects businesses against
risks. Some principal subtypes of business insurance are (a) the various kinds of
professional liability insurance, also called professional indemnity insurance,
which are discussed below under that name; and (b) the business owners policy
(BOP), which bundles into one policy many of the kinds of coverage that a business
owner needs, in a way analogous to how homeowners insurance bundles the
coverage that a homeowner needs.

Are the traders and intermediaries engaged in trading/processing of agricultural
commodities eligible for agricultural credit?

Loans to entities exclusively engaged in processing, packaging and marketing of
agricultural produce shall not fall under agricultural financing and would be covered under
commercial or SME financing. However, agricultural financing can be extended to entities
(including corporate farms, partnerships and individuals) engaged in farming activity as
well as processing, packaging and marketing of mainly their own agricultural produce,
provided 75% of the agriculture produce being processed, packaged and marketed is being
produced by the abovementioned entities themselves.

Is mark-up rate fixed by SBP on agricultural loans?

SBP does not fix any maximum/minimum mark-up rate to be charged on agricultural loans.
Banks’ mark-up is based on their cost structure and risk profile of the borrowers and the
sector. However, for benchmarking, Karachi inter-bank Offered Rate (KIBOR) is used by
banks for the purpose.

Revolving Credit Scheme was introduced in 2003 in consultation with banks. Under the
scheme, banks can provide finance for agricultural purposes on the basis of revolving limits
for a period of three years with one-time documentation. The borrowers are required to clear
the entire loan amount (including mark-up) once in a year at the date of their own choice.

Multiple withdrawals are allowed and the borrowers are also allowed to make partial
repayments. Only the amount utilized by the borrower will attract mark-up. This facility can
be availed by the farmers just like “running finance”. The limits under this scheme are
automatically renewed on annual basis without any request or fresh application.

Can Government of Pakistan Lay a Pivotal Role in this Sector?

In the recent past SMEDA stands out as a significant step towards Govt of Pakistan
commitment to SME development. Created as an autonomous institution with private
sector led governance structure, SMEDA promises to become an important institution
spearheading Government’s SME development efforts. However, in absence of a
coherent SME development policy framework it is unrealistic to expect a single
organization such as SMEDA, to be able to implement aggressive SME development
initiatives because:

Issues to be addressed for SME development fall within the purview of a
large number of Ministries and Departments at the Federal, Provincial and
Local government levels. SMEDA has no institutional jurisdiction or linkage
with such institutions; and

SMEDA has limited budget and manpower, posing restrictions on its
capacity to launch capital intensive initiatives and extend its outreach Thus to
provide a coherent policy mechanism, there is a need to develop a
comprehensive SME Policy for Pakistan that defines the role of concerned
public sector institutions. Such a Policy framework will provide the required
direction and focus for achieving SME led economic growth resulting in job
creation and reduction in poverty. Private sector growth in SME sector (as
opposed to the large scale manufacturing) will result in lesser investments
per job created, wider geographic and social spread of investments and better
income distribution.

SME Policy & Their Objectives

The objective of SME Policy is to provide a short and a medium to long- term policy
framework with an implementation mechanism for achieving higher economic
growth based on SME led private sector development.

The SME Policy suggests concurrent and specific policy measures in all possible
areas of SME development:

Financial Crimes

What is Money Laundering?

Defined in non-technical terms, money laundering is the conversion of 'dirty' money into -
seemingly - 'clean' money. Dirty money is money that meets the following conditions: (1) it
has been derived by illegal means and (2) for an outside observer it is possible to identify
that condition (1) applies. Money laundering is the practice of engaging in financial
transactions in order to conceal the identity, source, and/or destination of money, and is a
main operation of the underground economy. In the past, the term "money laundering" was
applied only to financial transactions related to organized crime. Today its definition is
often expanded by government regulators to encompass any financial transaction which
generates an asset or a value as the result of an illegal act, which may involve actions such
as tax evasion or false accounting. As a result, the illegal activity of money laundering is
now recognized as potentially practiced by individuals, small and large businesses, corrupt
officials, members of organized crime (such as drug dealers or the Mafia) or of cults, and
even corrupt states, through a complex network of shell companies and trusts based in
offshore tax havens. The increasing complexity of financial crime, the increasing
recognized value of so-called "financial intelligence" in combating transnational crime and
terrorism, and the speculated impact of capital extracted from the legitimate economy has
led to an increased prominence of money laundering in political, economic, and legal
debate.

Process of Money Laundering

Money laundering is often described as occurring in three stages: placement, layering, and
integration.

Placement: refers to the initial point of entry for funds derived from criminal
activities.

Layering: refers to the creation of complex networks of transactions which attempt
to obscure the link between the initial entry point, and the end of the laundering
cycle.

Integration: refers to the return of funds to the legitimate economy for later
extraction.

DFIs & Risk Management

Risks are usually defined by the adverse impact on profitability of several distinct sources
of uncertainty. While the types and degree of risks an organization may be exposed to
depend upon a number of factors such as its size, complexity business activities, volume etc,
it is believed that generally the banks face Credit, Market, Liquidity, Operational,
Compliance / legal / regulatory and reputation risks. Before overarching these risk
categories, given below are some basics about risk Management and some guiding
principles to manage risks in banking organization.

Risk Management

Risk management is the human activity which integrates recognition of risk, risk
assessment, developing strategies to manage it, and mitigation of risk using managerial
resources. The strategies include transferring the risk to another party, avoiding the risk,
reducing the negative effect of the risk, and accepting some or all of the consequences of a
particular risk. Some traditional risk managements are focused on risks stemming from
physical or legal causes (e.g. natural disasters or fires, accidents, death and lawsuits).
Financial risk management, on the other hand, focuses on risks that can be managed using
traded financial instruments. Objective of risk management is to reduce different risks
related to a pre-selected domain to the level accepted by society. It may refer to numerous
types of threats caused by environment, technology, humans, organizations and politics. On
the other hand it involves all means available for humans, or in particular, for a risk
management entity (person, staff, and organization). In every financial institution of
Pakistan, risk management activities broadly take place simultaneously at following
different hierarchy levels.

Strategic level: It encompasses risk management functions performed by senior
management. For instance definition of risks, ascertaining institutions risk appetite,
formulating strategy and policies for managing risks and establish adequate systems
and controls to ensure that overall risk remain within acceptable level and the reward
compensate for the risk taken.

Macro Level: It encompasses risk management within a business area or across
business lines. Generally the risk management activities performed by middle
management or units devoted to risk reviews fall into this category.

Micro Level: It involves ‘On-the-line’ risk management where risks are actually
created. This is the risk management activities performed by individuals who take
risk on organization’s behalf such as front office and loan origination functions. The
risk management in those areas is confined to following operational procedures and
guidelines set by management.

Banking Fraud & Misleading Activities

Bank fraud is a federal crime in many countries, defined as planning to obtain property or
money from any federally insured financial institution. It is sometimes considered a whitecollar
crime.

• Rogue Traders

A rogue trader is a highly placed insider nominally authorized to invest sizeable funds on
behalf of the bank; this trader secretly makes progressively more aggressive and risky
investments using the bank's money, when one investment goes bad, the rogue trader
engages in further market speculation in the hope of a quick profit which would hide or
cover the loss. Unfortunately, when one investment loss is piled onto another, the costs to
the bank can reach into the hundreds of millions of dollars; there have even been cases in
which a bank goes out of business due to market investment losses.

• Fraudulent Loans

One way to remove money from a bank is to take out a loan, a practice bankers would be
more than willing to encourage if they know that the money will be repaid in full with
interest. A fraudulent loan, however, is one in which the borrower is a business entity
controlled by a dishonest bank officer or an accomplice; the "borrower" then declares
bankruptcy or vanishes and the money is gone. The borrower may even be a non-existent
entity and the loan merely an artifice to conceal a theft of a large sum of money from the
bank.

• Wire Fraud

Wire transfer networks such as the international SWIFT inter-bank fund transfer system are
tempting as targets as a transfer, once made, is difficult or impossible to reverse. As these
networks are used by banks to settle accounts with each other, rapid or overnight wire
transfer of large amounts of money is commonplace; while banks have put checks and
balances in place, there is the risk that insiders may attempt to use fraudulent or forged
documents which claim to request a bank depositor's money be wired to another bank, often
an offshore account in some distant foreign country.

The Collapse of ENRON

Only months before Enron Corporations bankruptcy filing in December 2001, the firm was
widely regarded as one of the most innovative, fastest growing, and best managed
businesses in the United States. With the swift collapse, shareholders, including thousands
of Enron workers who held company stock in their 401(k) retirement accounts, lost tens of
billions of dollars. Investigations of wrongdoing may take years to conclude, but Enron’s
failure already raises financial oversight issues with wider applications. This lecture briefly
examines the accounting system that failed to provide a clear picture of the firm’s true
condition, the independent auditors and board members who were unwilling to challenge
Enron’s management, the Wall Street stock analysts and bond raters who missed the trouble
ahead, the rules governing employer stock in company pension plans, and the unregulated
energy derivatives trading that was the core of Enron’s business. Formed in 1985 from a
merger of Houston Natural Gas and Inter-north, Enron Corporation was the first nationwide
natural gas pipeline network. Over time, the firm’s business focus shifted from the regulated
transportation of natural gas to unregulated energy trading markets. The guiding principle
seems to have been that there was more money to be made in buying and selling financial
contracts linked to the value of energy assets (and to other economic variables) than in
actual ownership of physical assets. Until late 2001, nearly all observers – including
professional Wall Street analysts – regarded this transformation as an outstanding success.
Enron’s reported annual revenues grew from under $10 billion in the early 1990s to $101
billion in 2000, ranking it seventh on the Fortune 500. Several committees in the House and
Senate have held or plan to hold hearings related to Enron’s fall. The Justice Department is
conducting a criminal investigation. The challenge for financial oversight, however, does
not depend on findings of wrongdoing. Even if no one at Enron did anything improper, the
swift and unanticipated collapse of such a large corporation suggests basic problems with
the U.S. system of securities regulation, which is based on the full and accurate disclosure
of all financial information that market participants need to make informed investment
decisions.

Classic Financial Scandals

"Bankers who hire money hungry geniuses should not always express surprise and
amazement when some of them turn around with brilliant, creative, and illegal means
of making money." “The quotation is from a speech by the financial thriller writer on the
Psychology of Risk, Speculation and Fraud, at a conference on EMU in Amsterdam.
Barings Bank collapsed when one of the Singapore based employees of London's Barings
Bank, Nick Leeson, lost £827 million (US$1.4 billion) - primarily on futures contract
speculation. Leeson's actions led the oldest merchant bank to default on its debts. The bank's
collapse is considered a pivotal turning point in the history of banking and has become a
textbook example of accounting fraud.

• Internal auditing

The way that Barings Bank's activities in Singapore were organized between 1992 and 1995
enabled Leeson to operate effectively without supervision from Barings Bank's head office
in London. Leeson acted both as head of settlement operations (charged with ensuring
accurate accounting) and as floor manager for Barings' trading on Singapore International
Monetary Exchange (SIMEX). Normally the positions would have been held by two
employees. This concentration of functions placed Leeson in the position of reporting to an
office inside the bank which he himself held. Several observers, including Leeson, placed
much of the blame on the bank's own deficient internal auditing and risk management
practices.

• Corruption

Because of the absence of oversight, Leeson was able to make seemingly small gambles in
the futures market at Barings Futures Singapores (BFS) and cover for his shortfalls by
reporting losses as gains to Barings in London. Specifically, Leeson altered the branch's
error account, subsequently known by its account number 88888 as the "five-eight account,"
to prevent the London office from receiving the standard daily reports on trading, price, and
status. Leeson claims the losses started when one of his colleagues bought contracts when
she should have sold them. By December 1994 Leeson had cost Barings £200 million but he
reported to British tax authorities a £102 million profit. If the company had uncovered his
true financial dealings then, collapse might have been avoided as Barings had capital of
£350 million